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With GDP plummeting and an expected decline in foreign direct investment (FDI), Montenegro is heading for a hard landing in 2010, according to rating agency Standard & Poor's

GDP contracted by an estimated 6.7% in 2009 and is expected to fall by a further 2.5% in 2010. As such, S&P lowered its sovereign long-term rating for Montenegro from 'BB+' to 'BB' on March 31 and assigned the country a negative outlook, pointing to further downgrades.

The rating agency cites the large macro-financial risks that the country faces, which are putting more pressure on the public finances after last year's decline in GDP and the reversal of Montenegro's credit stimulus. The country's banks have also seen a deterioration in their loan portfolios. "In our view, Montenegro's government continues to be vulnerable to indirect and contingent risks associated with the significant pressure on its real economy and banking system, and deteriorating asset quality," says S&P credit analyst Marko Mrsnik.

During 2009, Montenegro's current account deficit narrowed to around 18% of GDP, down from around 30% the previous year. The deficit was more than covered by strong inflows of FDI, which have buoyed the economy in recent years. However, this situation is expected to change in 2010. After reaching around 30% of GDP in 2009, FDI is likely to decline as the wave of privatisations of key Montenegrin assets tails off, as do real estate-related investments.

Euro effects

S&P also warns of a possible increase in government debt as a result of the expected reduction in Monetnegro's tax base. "The negative outlook reflects our assessment of the possibility that worsening budget and economic trends may increase government debt as a percentage of annual output beyond our current expectations," says Mrsnik. "In addition, it incorporates the possibility that substantial contingent liabilities may become real ones on Montenegro's general government balance sheet, further increasing government debt to over and above our current expectations."

Since Montenegro has de facto adopted the euro as its currency, the country lacks exchange rate flexibility. The current deceleration in wage growth and inflation could result in growing deflationary pressures as the economy adjusts to regain lost competitiveness, according to S&P. "We expect the most tax rich components of economic growth, in particular domestic demand, to be weak in the next couple of years," the agency says.